Sample Question #203 (financial modeling case question)

We trade mortgage-backed securities here and our biggest concern is prepayment risk. How would you model this risk? Offer as many suggestions as you can and, for each suggested model, discuss its pros and cons.

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ANSWER

Any kind of financial modeling can be done in two ways: mathematical modeling, and statistical modeling. (Simulation techniques can be found in either framework, or cuts across both.)

Mathematical modeling means creating some theoretical model that describes the problem and attempts at a specific answer. Then one would run some data to see if the model makes sense.

Statistical modeling emphasizes regressions: take the variable of interest as the dependent variable and come up with some exogenous variables that would explain its behavior.

So you should offer some ideas from both frameworks. Mathematically, you can think in terms of option pricing (for the consumers), or in some kind of optimization framework (e.g., consumers maximizing utility functions with mortgage payment as a variable).

Statistically, you can regress prepayment history on some independent variables like interest rate, unemployment rate, etc.